With three of South Africa’s large construction companies having gone bankrupt in the last few months, many are questioning the future of the sector. However, while the deterioration of these companies may have hurt those investors exposed to them, it has left the gate open for others.
Historically the construction sector delivers poor returns, which simply comes down to bad industry economics. Large dominant clients are in a position to dictate the terms and conditions of their contracts to construction companies, which often leads companies agreeing to risky projects.
Accounting conventions allow construction companies to book profits against uncertified revenue, potentially resulting in inflated earnings, and against this backdrop, many construction companies in South Africa have been ill-prepared to survive other challenging industry issues.
We are currently near the bottom of a very bad cycle within the construction sector, arguably the worst that these construction companies have had to endure and leading to the largest construction companies in the country either going bust or exiting the industry altogether. Few have survived, which can be attributed to a handful of key factors.
The construction industry had a boom about 10 years ago during the build-up to the Fifa World Cup in South Africa, but has been in decline ever since. The industry has been hit by disastrous projects, often offshore, as well as fines by government following allegations of collusion during the World Cup, unhappiness around the mining charter and, of course, political uncertainty.
The building of trains, airports and shopping malls, among other large projects, happened at the peak of the cycle a decade ago, and as it rolled off there wasn’t work of that magnitude to replace it. The construction boom petered out as the economy got tougher.
The companies exiting the sector, voluntarily or otherwise, have left the industry to one or two well-managed companies that have navigated these tough times relatively well.
This is the time to invest in surviving construction companies as you’re buying them at good prices. Capital is exiting the market, meaning there are fewer players competing for profit. The key is to invest in a company that will survive the ups and downs. Currently, there are only a select few construction companies in the country that can handle larger construction projects.
The industry has shrunk dramatically and the prospect of new players entering the market is years away. This leaves the few remaining companies to handle demand.
The market is paying very little for companies in this sector seeing that expectations continue to be extremely low at the moment. Revenues, margins and profits have fallen, taking valuations to low levels. When their earnings eventually do grow, so will their margins and profits, which should eventually lead to better multiples and higher share prices.
Arthur Karas is co-portfolio manager of the Old Mutual Flexible Fund at Old Mutual Investment Group.